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Cisco announced a solid set of Q1 FY 2013 results November 13th as revenues grew close to 6% and operating income 20% over the same period last year. The networking giant continued to perform better than rivals such as
Juniper Networks despite a challenging macro-environment - a good sign that its turnaround efforts in shoring up key routing and switching businesses are paying off. Macro-economic concerns surrounding the Euro debt crisis however continued to weigh on network spending in Europe, which accounts for close to 20% of Cisco’s revenues. This was however largely offset by sales in the U.S. which sustained its recent strong showing and the emerging markets in Asia-Pacific which grew at a healthy 10% y-o-y.

Cisco’s strong showing this quarter, on the back of an improving business outlook in the U.S., helped the company’s stock jump almost 9% in post-market trading after the results were announced. However, we see far more value in the stock coming from Cisco’s renewed focus on its networking division. The networking giant has of late tried to scale back its ambitions to diversify into 30 new businesses and instead focus on those areas that add value to its core routing and switching businesses. As a result, it has restructured its operations and cut jobs in areas that are not its core focus, making the organization leaner and more efficient.

We believe the company is going in the right direction since the moves not only allow it to innovate faster but also streamline its businesses around its core networking products that contribute almost 40% to our estimated $26.50 fair value for Cisco, with cash contributing another 20%. At the same time, it helps Cisco benefit more from the long-term growth trends of data demand and cloud computing which continue to remain sharp. Our price estimate is about 45% ahead of the current market price.

Margins stabilizing

The cost cutting and restructuring seems to be paying off for the company not only in terms of market share gains but also operating margins which are stabilizing at >20% levels, after having fluctuated widely in recent quarters. This increases confidence in the management’s guidance of achieving a long-term operating margins in the mid-20s and increasing profits at a faster pace than revenues. Cisco has realized almost all of the expected $1.1 billion in severance charges related to the workforce reduction program it had announced in July 2011, and the operating margins should remain fairly stable from hereon. With savings achieved on the operating side, Cisco will be able to make aggressive price cuts to compete better with low-cost rivals and gain even more market share.

Fundamentals drive Cisco’s future earnings

As for top-line growth, we believe Cisco’s fundamentals remain solid due to the ongoing transition from wired to wireless networks, the burgeoning usage of data on both mobile and wired networks as well as a strong demand for cloud-computing routing solutions on the enterprise side. The company recently debuted its virtual cloud-routing and WAN optimization platform under the Cisco Cloud Connected Solution brand to enable businesses that are increasingly looking to move their applications to the cloud at a low cost. (see Cisco’s Worth $23 On Cloud Foray And Enterprise Strength) Its recent move to acquire NDS Corp was made to drive device-agnostic video consumption and increase the demand for its routers and switches among service providers that are looking to monetize the booming data demand. (see Cisco’s NDS Acquisition Taps Video Demand To Boost Network Equipment Business)

What was reassuring this quarter was that despite a challenging macro-environment, Cisco’s revenues from enterprises and service providers in the U.S. saw a strong y-o-y growth of 9% and 13% respectively. U.S.’ return to strength is a big boost for Cisco, since almost 60% of its revenues come from the region. Moreover, with wireless carriers such as AT&T recently announcing almost $14 billion in network spending over the next three years and Sprint building out its LTE network aggressively, emboldened by its recent deal with Softbank, Cisco’s revenues from the U.S. could see a nice boost in the coming years.

Overall, we believe that Cisco has executed well on its turnaround plans so far and is well-positioned with its new-found focus to gain even higher ground going forward. (see Cisco’s Post-Earnings Crash Makes The Stock Look Incredibly Cheap) The company’s dominant market position as well as aggressive price cuts have helped it gain market share from rivals Juniper and Alcatel-Lucent in an uncertain economic environment so far, and could help it even further when the concerns subside. However, Alcatel Lucent’s recent foray into core routers poses a downside risk for Cisco seeing as the former is #2 in edge router market share – a position of strength that it can effectively leverage to provide an end-to-end solution to its customers.